Correlation, A Hidden Risk To Your 60/40 Portfolio

What if stocks and bonds move down at the same time?

What do your stocks, house, car, lawnmower, and expensive jewelry all have in common? If things get financially desperate enough, you’ll sell them all. At first thought one might assume that there is no real correlation between a lawnmower and a car, but in times of serious stress they all have to go…at the same time! If you think your real estate is worth $500k, maybe you’ll take $495k, but what if you have to sell it in a month no matter what? How about a week? How about a day?

The typical recommended portfolio of 60% of your assets in equities and 40% in bonds has worked well for a long time. The data supports the idea, bonds have been in a bull market since the early 1980’s, and yields have been headed down in kind. Most of the time when stocks go down enough, bonds often go up. And because of this negative correlation it has made sense to have both in your portfolio, bonds acting as a safe haven from stocks and vice versa.

In 1982 with rates at 15% there was a lot of room for bonds to go up (rates down). But now in 2021 with the same rate at 1.4%, it’s not the same. Rates can’t go down another 13.5%. Sure rates can go down 1.4%, to zero, or even negative but there is no data to support a deeply negative interest rate environment. Moreover, with the Fed ending their bond purchase program there will be less downward pressure on rates at the exact same time that inflation is higher than it’s been in decades (The Fed are still buying bonds every month but have signaled they will decrease this purchase by $30 billion per month through the beginning of 2022, ending Quantitative Easing).

10-year-note yields have been on a steady decline since President Reagan tasked Fed Chairman Paul Volker with fighting the inflation of the 1970’s.

While none of us know where the stock or bond market will go, most people have some risk exposure to the standard retirement concept of a 60/40 portfolio whether in their 401k, IRA, mutual funds, etc. This has become a fixture of the modern portfolio but the massive weakness with this plan is that it is predicated on the negative correlation between stocks and bonds…but what happens to a retirement account if this relationship breaks down? What happens if the relationship changes to a positive correlation, stocks and bonds both down at the same time? Inflation is the main reason rates will go up, but if the Fed were to raise rates to fight inflation it could ruin the economy. Consider a 30-year fixed mortgage where the debt on the property is $1m. With an interest rate of 3.5%, the payment would be around $4,500. However, if the interest rate was 8.5%, the payment would balloon to just under $8,000. Very few Americans could afford this percentage change in their financial obligations. A change in rates of this magnitude would clearly destroy demand for real estate, causing prices to plummet. Inflation (as of this writing) is at its highest since the 1980s, arguably higher (note the Boskin Commission).

The S&P 500 ETF, SPY and the long-term bond ETF, TLT. The correlation between SPY and TLT is shown below in blue. Numbers between -1 and 0 are a negative correlation and numbers between 0 and +1 are positive correlation.

Historically, stocks and bonds have had long periods of positive correlation but not since the 1980’s when most portfolios were constructed, the effect of stocks down and bonds down on the Baby Boomer generation would be devastating. So what is the answer? Real Estate? Hedge Funds? Commodities? Gold? Bitcoin? The problem is that all of these can go down if the economy as whole really starts to struggle, there is one asset class that will very likely do well if the rest of these struggle: volatility. The concept is simple, if things get messy then asset prices will swing much more violently and historically volatility has almost always gone up when stocks go down.

True diversification takes into account not just the current correlations but also how these correlations will change if prices change dramatically in the future. For that reason, volatility as an asset class can be an extremely valuable part of a truly diversified portfolio.

S&P 500 vs VIX. The VIX volatility index tends to rise when the stock market goes down.

Convex Asset Management LLC emphasizes that investing in futures, options, and other derivatives involves substantial risk and is not suitable for all investors. There is a possibility that you may sustain a significant loss, including a complete loss of your investment capital. Past performance is not necessarily indicative of future results. Investing involves risks, and any investment strategy carries the risk of loss. Before investing, carefully consider your financial objectives, level of experience, and risk tolerance. You should only invest funds that you can afford to lose and seek independent financial advice if you have any concerns or questions.